Are VIX Traders Riding the Wrong Roller Coaster?

It's safe to say there's a lot of misguided money chasing volatility.

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Trading stock market volatility is not for the faint of heart. And if you're a volatility trader, you've either personally experienced or are at least aware of the performance discrepancies between the CBOE S&P 500 Volatility Index (INDEXCBOE:VIX) and VIX exchange-traded products (ETPs) like the iPath S&P 500 VIX ST ETN (NYSEARCA:VXX).

Leading up to the last minute agreement by US politicians to suspend the debt ceiling, we suggested owning volatility by using VIX call options, not VIX ETPs. We bagged a 30% gain on the above mentioned VIX call options three-week trade that began on Sep. 23 and ended on Oct. 14, and were right in the thick of the perfect storm.

For the one-month ending Oct. 15, the VIX easily beat all major asset classes with a sizzling 29.4% gain. Over that very same tumultuous period, the S&P 500 (INDEXSP:.INX) was modestly down -0.36% and gold, an alleged safe-haven, was down even more by -2.15%.

But through this turmoil, VIX-focused ETPs badly trailed the VIX.

The latest prospectus (dated July 31, 2013) for the ProShares VIX Short-Term Futures ETF and the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) allude to some of the problems with getting VIX exposure via ETPs.

Here are a few excerpts:

"High volatility may have an adverse impact on the VIX Funds beyond the impact of any performance-based losses of the underlying indexes, especially the geared (or leveraged) fund may perform differently than the Short-Term Index."

"The VIX Funds are benchmarked to the Short-Term Index. They are not benchmarked to the VIX or actual realized volatility of the S&P 500. The level of the Short-Term Index is based on the value of the relevant futures contracts ("VIX futures contracts") based on the Chicago Board Options Exchange, Incorporated (CBOE)."

"The VIX is not directly investable."

How did ProShares Trust II (NYSEARCA:VIXY) perform during the stock market's latest bout with high volatility? From Sep.15 to Oct. 15, VIXY gained just +8.38% whereas the VIX itself jumped 29.4%.

"Traders need to remember that VIXY gives you exposure to the front two month VIX futures contracts. There can be a disconnect in the performance between VIX futures and the VIX index that results in different performance out of VIXY and VIX," said Russell Rhoads, CFA an instructor with the Options Institute at the Chicago Board Options Exchange and author of Option Spread Trading: A Comprehensive Guide to Strategies and Tactics (2011, Wiley).

With roughly $3 billion scattered across 20 different US listed volatility ETPs, it's safe to say there's a lot of misguided money chasing volatility.
If you're going to trade stock market volatility or the VIX, make sure you're on the right roller coaster.

Editor's note: This story by Ron DeLegge originally appeared on ETFguide.com.